Risk Is Shifting, So Shift With It

04/08/2011 8:00 am EST


Jim Jubak

Founder and Editor, JubakPicks.com

With central banks in developed countries raising rates, investors should consider moving assets back into emerging-market stocks.

You can circle this week on your calendar.

For the last six months, the world's emerging stock markets have been riskier than their developed-market peers. For the next six months—and perhaps longer—the world's developed markets will carry the greater risk. And in my opinion, you ought to start weighting your portfolio to reflect that shift.

Why assign the shift to this week in particular?

The interest-rate increase from the European Central Bank today is not much—just a move to a 1.25% benchmark rate, from the historic low of 1%—but it does mark the beginning of a cycle of rate increases in the big developed economies of the European Union, the United Kingdom, and the United States.

I think central banks in all three of these economies are about to embark on a cycle of interest-rate increases that will stretch well into 2012.

The European Central Bank, the Bank of England, and the US Federal Reserve are all looking to slow rising inflation—although with different degrees of urgency, and different timetables. To fight inflation, the banks will raise interest rates, slow or reverse growth in money supply, and lower economic growth rates.

Slower growth, tighter money and higher interest rates have not historically been good for stock prices. At the least, they act as a drag on any potential rally.

Six months ago, it was the emerging economies of Brazil, China, India, Indonesia, and Turkey that were at the beginning of a cycle of multiple interest-rate increases, policy moves to restrict growth in the money supply, and lower growth rates.

Those cycles of rate increases are not over, but in some countries I can see increases ending within a quarter or two. And in some of these economies, the slowdown that these policies were intended to produce has already visibly taken hold.

Stocks in these markets could still move somewhat lower in the near term as expectations for growth move from reasonable to extremely pessimistic. But the end of the downward pressures is in sight.

A Tale of 2 Markets
Contrast these two sets of markets, emerging and developed, using Brazil and the European Union as examples.

In Brazil, the Banco Central do Brasil aggressively raised interest rates to 11.75% starting in April 2010. The economy has started to slow, even though inflation has continued to climb.

But the financial markets are pricing in an end to a cycle of rate increases that began with the benchmark Selic rate at 8.75%. Expectations are high that the central bank will raise the benchmark again in April, but also that the top to this cycle—likely 12.5%—isn't so far away.

Inflation will peak at 6.5% in the third quarter, the consensus now holds, and then gradually pull back to the central bank's target of 4.5% in 2012.

In other words, at some point not too far down the road, investors will be able to start anticipating not just an end of increases in interest rates—but below-target inflation, potential interest-rate cuts, and rising economic growth.

NEXT: Europe Doesn't Look So Rosy


Europe Doesn't Look So Rosy
Contrast that with the situation in the European Union after today's interest-rate increase. The financial markets now project that the central bank will raise rates three times in 2011—in small, 0.25-percentage-point increments.

But that doesn't mean the cycle will include only those three increases. In March, inflation climbed to a two-year high of 2.6%—well above the bank's target of close to, but not above, 2%.

Unlike the US Federal Reserve, the European Central Bank includes food and fuel costs in its inflation measures, and with prices in both those sectors climbing, getting inflation under control won't be easy.

The three rate increases projected by financial markets in 2011 aren't really an indication that the markets think the job will be easily accomplished after just those moves.

Rather, I think the projection is an indication of how carefully the markets think the European Central Bank will have to move to avoid turning inflation-fighting measures into a new and deeper crisis for Greece, Ireland, Portugal, and the other budget-challenged members of the European Union. The bank can't fight inflation as vigorously as it might prefer, the markets are saying, because it doesn't want to completely tank the Eurozone's weakest economies.

In other words, there's really no end in sight here. The central bank will raise interest rates as aggressively as it can and reduce economic growth as much as it can, but no one really knows how long this cycle will last.

What About Fiscal Policy?
Monetary policy isn't the only area in which risk is headed in different directions in the emerging and developing markets at the moment. There's also the little matter of fiscal policy. On this front, let's contrast Brazil and the United States.

On April 4, Fitch Ratings upgraded Brazil's credit rating again, to BBB from BBB-. Brazil earned its first investment-grade rating—ever—in April 2008.

In upping the country's rating this week, Fitch cited strong growth trends in the economy and signs that President Dilma Rousseff was "exercising greater fiscal restraint." Brazil's finance minister, Guido Mantega, called the upgrade "an acknowledgment that the Brazilian economy is increasingly stable and doesn't present risks."

Can you think of anyone outside Arkham Asylum who would apply those terms to the United States at the moment? The current budget deficit seems restrained only in comparison to projections that show it headed to the stratosphere as the population ages and government spending on health care eats up all federal income.

Serious discussions about the credit rating of the country focus on whether any of the credit-rating companies will have the guts to downgrade the world's largest economy—which is also the world's largest debtor.

I can name a handful of emerging economies that have seen upgrades in the last few years to investment grade (or better) or are headed in that direction—Brazil, Turkey, Indonesia, Colombia, and Peru come to mind. I can't think of a single major developed economy that isn't looking at the possibility of a downgrade.

All things being equal, upgrades mean lower interest rates, faster economic growth, and higher stock and bond prices (as investors decide that these assets carry less risk). Downgrades mean higher interest rates, slower growth and lower asset prices.

NEXT: Higher Risk Leads to...Higher Risk


Higher Risk Leads to...Higher Risk
The world's central banks know they have to tread with incredible caution in raising interest rates, since higher oil prices—which feed into inflation—also slow economic growth.

But the world's central banks don't all have the same room for error. A central bank trying to lower inflation in an economy growing at 2.5%, with rising oil prices, doesn't have the same leeway as a central bank in an economy growing at 5%, 7%, or more.

A mistake in the first situation could tip an economy into recession. A mistake in the second situation could, well, reduce growth from 7% to 3%.

For all these reasons, I think the smart move now is to reduce your portfolio exposure to the riskier developed economies of the world, and increase your exposure to the least risky of the world's emerging economies.

You don't need to dump everything in developed markets—that's not the point of this kind of relative risk assessment. What I think you should do is reduce the risk in your portfolio by shifting market weightings, and by selling stocks that look extended or that would fall inordinately if risk within individual markets went from being theoretical to actual.

You don't need to do all this today—although starting this kind of reallocation when stocks in developed markets are near highs is a good idea.

Take your time and go through your portfolio, looking for overextended or underperforming stocks to sell. And don't load up on just any emerging market-stock. Remember that some emerging-market stocks, especially the big commodity producers, are incredibly sensitive to fears of lower growth in developed markets.

In the coming days, I'll have a few suggestions for emerging-market stocks that you can use as part of this portfolio reallocation.

It would be a reasonable goal to have this process pretty much completed by sometime around the end of the second quarter or the beginning of the third.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of January, see the fund’s portfolio here.

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